Taught By

Andrew Metrick

Timothy Geithner

Transcript

[MUSIC] All right, so where are we? Historically, we would use precious metals for our safe assets. There's only so much gold in the ground. Can't be carrying gold around, it's the only way you can transact. We can use the debt and currency of stable countries. What we've seen is by 2007, we're running out of US securities for this purpose. Insured deposits in commercial banks are another solution. There's not enough supply of them in the United States either. What the financial system is good at, is when there is excess demand for some specific type of financial instrument. In this case safe assets. You can expect the financial system to try to manufacture it. That's what it's been doing since the beginning of the financial system. That's what bank notes were, in the early 19th century in the United States. That's what demand deposits became in the second half of the 19th century. And that's what effectively the shadow banking types of activities that we saw in the 21st century are. What does it mean to manufacture safe assets? The key principle is that you take an asset and you use only part of it as collateral. So for example, my house would not count as a safe asset under any definition. Nobody would be willing to accept from me, or from any financial intermediary that helped me do it, a even fractional share of my house as the payment for something. If someone came to you and said, here's 1% of my house. Here's a certificate that's worth 1% of my house. I'm going to use that as currency. The estimated value of my house is $300,000. So, here's $3,000 of something that you'll use as currency. You would never do that. You would think, how can I possibly accept 1% of your house as payment? I would have to go and figure out what your house is worth. Plus, I don't even know if I could even sell your house if I needed to sell it. There's certainly risk that's involved in that. So instead, what ultimately can happen is, I say all right, you're not gonna have just 1% of my house, how about this? You have the first $3,000 of the value of my house. The other 99% of my house, that's my problem. But you would get the last, that's your collateral. Your collateral is, if this loan doesn't get paid back, you get the very first $3,000. The most senior part of the loan. And that's how banks work it. So even when a bank that forces you to take a mortgage, what are they going to do? They're going to say, please put 20% down, less sometimes, but these days often 20% down. And then we will take the next 80%. And that's how the bank tries to make sure that things are safe. And that's basically the same strategy that we're going to use when we manufacture any safe asset. We're gonna take a bundle of things that, by themselves might not be safe. And then we're going to just take the most senior part of it, and try to use that as the creation of a safe asset. So our example of a house is very clear. You purchase a house, say for $1 million, this would be a more expensive house. How safe would the first $1,000 loan on this property be? How much work would you need to do to figure it out? Not very much. Similarly, think about how a company could do this? A large company has say a market capitalization of $100 billion, all equity, zero debt. Now this company is going to go and issue $1 million of debt, and that's it. Now this company is not a ponzy scheme, this company has products, this company has profits. That first million dollar of debt is going to be super safe. It's going to be so super safe that once it went through the normal securities process, we wouldn't really have to spend any time on it at all, to know that this is something that is effectively Triple A. The key here is to set the debt to value ratio low enough so that nobody has an incentive to analyze the fault probabilities. That's what information insensitivity means. I'm going to issue something, $1 million of debt or $1,000 loan on a $1 million property. And with that, the other side, the counterparty says, it's kinda pointless. I'm not gonna go and spend hours and hours trying to figure out if this is actually going to pay off, right. And I know that the other side won't do that either. This can now act as a form of collateral, as a safe asset in many types of transactions. [MUSIC]

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